Recession-watch shifts to Berlin

If Germany's economy is still contracting, there will be shock waves across Europe

IT LOOKS as though we can stop worrying about the UK economy for this year - or at least about domestic demand, for the plight of exporters remains serious. Good retail sales and more general signs of confidence in the housing market suggest there is now virtually no danger of recession, and the main issue will be whether growth turns out to be closer to 2 per cent than 1 per cent.

So the focus of Europe's recession-watchers shifts. And it must shift to Germany, for there is a real possibility that Germany has just experienced recession. We don't yet have GDP data for the first quarter of this year, but we know that the economy shrank by 0.4 per cent in the last quarter of 1998. We know too that retail sales were dreadful in February and that exports have been very weak.

It is probable that there has been a recovery in retail sales in March, for surveys of retailers were cheerful and in any case private consumption has not been quite as low as retail sales. But exports have probably remained weak and will stay weak though the first half of this year if the stats for new foreign orders are any guide (see graphs).

We will have to wait a bit longer to know whether Germany will qualify for a technical recession, the definition of which is two successive quarters of negative growth. Most private sector forecasters think Germany will just squeak by without it: both Deutsche Bank and HSBC, for example, are predicting 0.3 per cent growth. But if they are wrong, there will be a shock wave across Europe. This is not what was meant to happen.

What is happening, though? A brief visit to Berlin last week reminded me of the enormous differences, both regional and structural, that characterise Europe's largest economy. Berlin is not Germany, any more than London is England, but you can see both sides to the economy.

Go to Potsdamer Platz and you see around you the largest building site in Europe. Walk the side streets in the older East Berlin residential districts and they are full of middle-aged men doing nothing.

Looked at from a distance, Berlin is booming. The quality standards, not just of the construction industry but also of the service industries, mirror the standards of manufacturing that made Germany the world's largest exporter. But viewed up close the weaknesses, particularly in job creation, become more apparent. In Berlin, one in six of the workforce is unemployed.

IN A WAY the demand for quality - the thing that brings Germany its extraordinary success - is also a curse, for it brings with it a demand for quality employees, and thereby excludes the less well trained, the less able, and even the less lucky. It is a wonderful economy at creating quality goods but a dreadful one for creating jobs.

In one sense demography will help, for the German workforce is falling in size. That will limit the extent to which unemployment can rise. But in another sense that is a disaster, for although the workforce shrinks, the number of mouths to feed does not. So taxes will have to be even higher to support the social welfare costs.

This failure on the jobs front is primarily a long-term problem, while the stagnant demand this year is primarily a short-term one. But the former depresses the latter - fear of unemployment is a constant depressing factor on consumers' willingness to spend, as Japanese experience has taught us. Germany is not yet in Japan's position, where every effort to stimulate the economy seems to fail, and where banking weakness compounds economic weakness, but there are uncomfortable parallels.

And, unlike Japan, Germany no longer has control of its monetary policy. After that interest-rate cut to 2.5 per cent earlier this month, it cannot now expect any further monetary easing except as a by-product of the possible further decline in the euro.

Looking ahead, what should anyone trying to "call" the German economy look for?

As there is not likely to be any help on the monetary side, don't look there. Look a little at fiscal policy, for while there will be no direct effect on the economy this year - the lags are far too long for that - business and consumer sentiment will be profoundly affected by the way the government handles tax issues. Many people in the business community were disappointed that the planned reforms to company taxation were not modified once Oskar Lafontaine had resigned. Were the government now to start a constructive dialogue with business, really asking: "What do you want from us?", it could have a considerable effect on confidence. But we will have to see.

Consumers, for their part, will want to know what plans the government has for value-added tax. The main rate of VAT, 15 per cent, is low by European standards, which has led to suggestions that it will be raised. Were that to happen, Germany would risk the same damage to consumer demand as Japan imposed when it lifted the sales tax.

The problem is not so much the money raised, rather the psychological impact on the people who have to pay it. If you look at the total numbers, there is no leeway to cut taxation in German and remain within the Maastricht limits. So the only hope is to find ways of fine-tuning the tax system to encourage German consumers to be a bit less responsible - save less and spend more. Not an easy task.

If you have no control over monetary policy and virtually no leeway on fiscal policy what is there left? Answer - structural policies.

That is really the area on which Germany-watchers should focus. Is Germany ready to deregulate? If so, will there be a series of minor chips off the corners of the regulatory edifice? Or is more radical change possible? I don't know the answer, but I know that is the key question.